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Majority of people are unable or unwilling to analyze investments. People spend more time planning their vacations or buying a car than they do making an investment. So if a banker or a broker suggests an investment, it’s accepted without much deliberation. It’s from this premise that mutual fund industry developed. Since formation in 1924 in the United States mutual fund’s acceptance by the public has grown to become universal. In simple terms a mutual fund controls a pool of money provided by its shareholders that it invests in a portfolio of securities selected by the fund’s managers.  Contribution of money is the only involvement required by the investor. We go to a doctor when we need medical advice or a lawyer for legal guidance. Similarly we go to mutual fund manager for investing in equities. In recent years they have proliferated like mushrooms all over world and in India too.

Most of us are advised to invest in Mutual Funds – the diversification, fund manager will make investment decisions etc.  But what are the limitations of a mutual fund manager? Read an article in Morningstar “Why your manager may not act in your best interest.”(Mar 2012) Quoting from the article:

A mutual fund manager makes decisions on behalf of his or her fund’s investors. In the parlance of economics, the manager acts as an agent working on behalf of the investors (the meaning here is similar to the use in the term real estate agent). The financial agent generates income by acting to assist the client and represents the interests of the client. There are invariably potential conflicts of interest between agents and clients. Agents often have incentives to make decisions that are in their own best interests but which are not necessarily in the clients’ best interest.

A herding mentality: That a fund manager’s biggest risk is career risk, the risk that he substantially underperforms compared to the fund’s benchmarks or to other funds that are classified as peers and loses his job as a result. If the fund loses a lot of money when all of its peers also lose a lot of money, that is less likely to result in a change of fund manager, than if a fund manager takes a conservative stance and misses out on a big market rally. This situation leads to herding among fund managers. There is less career risk for fund managers to make decisions similar to one another. John Maynard Keynes described this exact scenario: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

A fund manager’s core dilemma: If you, the fund manager, have a big allocation to Apple (AAPL) when most of the other funds in your category also have big allocations to Apple, and Apple stock drops substantially, you are probably okay from a career standpoint. The media will report that Apple disappointed investors in its latest earnings and you don’t get singled out. On the other hand, if you load up on a stock because you believe that the evidence is that this stock is incredibly undervalued and that bet does not pay off, then you look like a bad fund manager. And, if your bet on that stock turns out to be correct, some people will be impressed but many others will attribute your success to luck (which may or may not be the case).

The key take-away to remember here is that a fund manager is faced with an agency problem. He or she wants to make the best investment decisions, but also knows that investors have a relatively short patience time and that the evidence suggests that you have more to lose (assets under management or, at the extreme, your job) by following your beliefs if they go against the crowd than you have to gain if you turn out to be correct.

Read the same thing in one of the reputed mutual fund manager Peter Lynch book Up on Wall Street.  The excerpts from the chapter The Wall Street Oxymorons are given below:

To the list of famous oxymorons include military intelligence, learned professor, deafening silence, and jumbo shrimp. Add the word professional investing to the list of famous oxymorons. It’s important for amateurs to view the profession with a properly skeptical eye. At least you’ll realize whom you’re up against. Since 70 percent of the shares in the major economics are controlled by institutions, it is increasing likely that you are competing against oxymorons whenever you buy or sell shares. Given the numerous cultural, legal and social barriers that restrain professional investors, it’s amazing that we’re done as well as we have as a group.

Not all professionals are oxymoronic -such as John Templeton, Max Heine, Peter deRoeth, George Soros, Jimmy Rogers. These exceptions are outnumbered by the run-of-the mill fund managers, dull fund managers, comatose fund managers, sycophantic fund managers, timid fund managers, plus other assorted camp followers, fuddy-duddies and copy cats hemmed in by the rules.
You have to understand the minds of the people in our business. We all read the same newspapers and magazines amd listen to economists. We’re a very homogenous lot.

Street Lag

Under the current system the stock isn’t truly attractive until a large number of large institutions have recognized it’s suitability and an equal number of Wall Street analysts(the researchers who track the various industries and companies) have put it on the recommended list. He gives example of company called The Limited which went public in 1969, when it was unknown to the large institutions and the big time analysts.  A lone analyst followed the company till second analyst took official notice of it in 1974.  In 1975 first institution bought it. In 1979 only two institutions owned Limited stock accounting for 0.6% of outstanding shares. In 1981 when 400 Limited stores were doing thriving business only 6 analysts followed it. Only in 1985 when stock was $15 that analysts joined in the celebration. Infact they were falling all over one another to put the Limited on their buy lists and aggressive institutional buying helped send the shares on the ride all the way upto $52 ⅞ way beyond what the fundamentals would have justified.  By then there were more than 30 analysts on the trail and many had arrived just in time to see the Limited drop off the edge. Contrast this with the 56 brokerage analysts who normally cover IBM or the 44 who cover Exon

Inspected by 4

Whoever imagines that the average Wall Street professional is looking for reasons to buy exciting stocks hasn’t spent much time on the Wall Street. The fund manager most likely is looking for reasons not to buy exciting stocks, so that he can offer the proper excuses if those exciting stocks happen to go up. “It was too small for me to buy” heads a long list followed by “there was no track record”, “the employees belong to a union” and “the competition will kill them”. These may be reasonable concerns that merit investigation but often they’re used to fortify snap judgments and wholesale taboos.

With survival at stake it’s the rare professional who has the guts to traffic in an unknown LA Quinta (stock). In fact, between the chance of making an unusually large profit on an unknown company and the assurance of losing only a small amount on an established company, the normal mutual-fund manager, pension-fund manager, or corporate-portfolio manager would jump at the latter. Success is one thing, but it’s more important not to look bad if you fail. There’s an unwritten rule on Wall Street: “You’ll never lose your job losing your client’s money in IBM.””
“If IBM goes bad and you bought it, the clients and the bosses will ask: “What’s wrong with the damn IBM lately?” But if La Quinta Motor Inns goes bad, they’ll ask: “What’s wrong with you?”” They don’t buy Wal Mart when the stock sells for $4 and it’s dinky store in a dinky little town in Arkansas, but soon to expand. They buy Wal Mart when there is an outlet in very large population center in America, 50 analysts follow the company and the chairman of Wal-Mart is featured in the People magazine as the eccentric billionaire who drives a pickup truck to work.

The worst of the camp following takes place in the bank pension fund departments and in the insurance companies, where stocks are bought and sold from pre approved lists. Nine out of ten pension managers work from such a list, “as a form of self -protection from the ruination of “diverse performance”

I am reminded here of the Vonnegut short story in which various talented practitioners are deliberately held back(the good dancers wear weights, the good artists have their fingers tied together etc), so as to not upset the less skillful. I’m also reminded of the little slips of paper that say “Inspected by 4” that are stuck inside the pockets of new shirts. The “Inspected by 4” method is how stocks are selected from the lists. The would-be-decision makes hardly know what they are approving. They don’t travel around visiting companies or researching new products, they just take what they’re given and pass it along. I think of this every time I buy shirts.
It’s no wonder that portfolio managers and fund managers tend to be squeamish in their stock selection. There’s about as much job security in portfolio management as there is in go-go dancing and football coaching. Coaches can at least relax between seasons. Fund managers can never relax because the game is played year round. The win and losses are reviewed every third month, by clients and bosses who demand immediate results.

It is more comfortable on my side of the business working for the general public, than it is for the managers who pick stocks for their fellow professionals. Shareholders at Fidelity Magellan tend to be smaller investors who are perfectly free to sell out at any time, but they don’t review my portfolio stock-by-stock to second guess my selections.  That’s what happens, though, to Mr. Boon Doggle over at Blind Trust, the bank that’s been hired to handle the pension accounts for White Bread, Inc. Fund managers in general spend a quarter of their working time explaining what they did – first to their immediate bosses in the trust department, and then to their ultimate bosses, the clients like Flint at White Bread Inc.

Oysters Rockefeller

Whenever fund managers do decide to buy something exciting (against all social and political obstacles), they may be held back by various written rules and regulations. Some bank trust departments simply won’t allow the buying of the stocks in any companies with unions. Others won’t invest in non-growth industries or in specific industry groups, such as electic utilities or oil or steel. Sometimes it gets to point that the fund manager can’t buy shares in any companu whose name begins with r, or perhaps the shares must be acquired only in months that have an r in theor name, a rule that’s been borrowed from the eating of oysters.
If it’s not the bank or the mutual fund making up the rules, then it’s the SEC. For instance, the SEC says that the mutual fund such as mine cannot own more than the ten percent of the shares in any given company, nor can we invest more than fice percent of the fund’s assets in any given stock.
The various restrictions are well-intentioned, and they protect against a fund’s putting all its eggs in one basket and also against a fund’s taking over a company a la Carl Ichan. The secondary result is that the bigger funds are forced to limit themselves to the top 90 to 100 companies, out of the 10,000 or so that are publicly traded.

Some funds are further restricted with a market capitalization rule; they don’t own a stock in any company below, say, a $100-million size. A company with 20 million shares outstanding selling for $1.75 a share has a market cap of $35 million and must be avoided by the fund. But once the stock price has tripled to $5.25 that same company has a market cap of $105 million and suddenly it’s suitable for purchase. This results in a strange phenomenon; large funds are allowed to buy shares in small companies only when the shares are no bargain.

By definition, then the pension portfolios are wedded to ten-percent gainers, the plodders, and the regular Fortune 500 big shots that offer few pleasant surprises. They almost have to buy the IBMs, the Xeroxes, and the Chryslers, but they’ll probably wait to buy Chrylser until it’s fully recovered and priced accordingly.  No wonder so many pension fund managers fail to beat the market averages. When you ask the bank to handle your investments, mediocrity is all you’re going to get in a majority of cases.

My biggest disadvantage is size. The bigger the equity fun, the harder it gets to outperform the competition. Expecting a $9 billion fund to compete successfully against an $800 million fund is same as expecting Larry Bird to star in a basket ball games with a five pound weight strapped to his waist. Big funds have the same built in handicaps as big anything’s – the bigger it is, the more energy it takes to move it.

Let me make it clear that I have nothing against mutual fund managers. Infact I have also invested in mutual funds. The only time I followed fund manager was- When Sandip Sabarwal moved from SBIMutual Fund, having given me great returns in SBI Contra , I invested in JM Basic NFO and burnt my fingers or rather my money. Then decided to invest in mutual fund which is more research based and not fund manager based and hence started investing in Fidelity Mutual Funds. Now with Fidelity being acquired by L &T  I am in fix. But while I was investing in mutual funds I was only worried about my investment, my returns. Never thought of the limitations of the mutual fund managers. MorningStar suggests-The simplest default solution is simply to focus on a low-cost diversified portfolio of index funds.

 This article and chapter kind of opened my eyes. What do you think? Are Mutual Fund Managers job easy? What should one think of before investing in mutual funds? Should one invest only in index funds?


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